A shift from S₁ to S₂ reflects the change that happens when a negative externality is taken into account. A shift from D₁ to D₂ reflects the change that happens when a positive externality is taken into account.
-Refer to the above figures. Externalities exist in both panels. After correcting for the externalities the prices should be
A)P₁ and P₃.
B)P₁ and P₄.
C)P₂ and P₄.
D)P₂ and P₃.

Question

A shift from S₁ to S₂ reflects the change that happens when a negative externality is taken into account. A shift from D₁ to D₂ reflects the change that happens when a positive externality is taken into account.
-Refer to the above figures. Externalities exist in both panels. After correcting for the externalities the prices should be
A)P₁ and P₃. 
B)P₁ and P₄. 
C)P₂ and P₄. 
D)P₂ and P₃.

Quizplus · Accepted Answer

In panel S, the negative externality results in a lower S₂, which reflects the true social cost. In panel D, the positive externality results in a higher D₂, which reflects the true social value. The intersection of the corrected S₂ and D₂ curves is at point P₄. Therefore, the correct prices are P₂ and P₄ (choice C). P₁ is the equilibrium price without accounting for the externality, and P₃ is the price that reflects the private cost or benefit.

A Shift from S₁ to S₂ Reflects the Change That